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Avoid a flood of uncertainty: draft to include costs that aren’t maintenance, repair, or replacement in a commercial lease

Avoid a flood of uncertainty: draft to include costs that aren’t maintenance, repair, or replacement in a commercial lease

Avoid a flood of uncertainty: draft to include costs that aren’t maintenance, repair, or replacement in a commercial lease

Regional Capabilities:

July 8, 2014

The flooding experienced by many parts of the country over the last year may be partly behind changes to the Ontario Building Code, changes designed to prevent the contamination of Ontario’s water supply system. The costs of complying with the new provisions have once again raised an issue of importance to landlords and tenants in commercial leases; who bears the responsibility and cost of an installation, change or upgrade to a property that does not fall into the category of maintenance, repair or replacement?

Buildings are increasingly subject to regulations requiring installation of new features, alterations or upgrades on the grounds of health and safety or public policy. When a new or revised legal requirement necessitates a new installation or a change or upgrade to a building, who should be responsible for paying the costs of complying with such regulations? Many leases are silent on the point, leaving the parties in limbo as to the responsibility and cost of compliance and at the risk of being in breach of the relevant law unless the issue is addressed. In some cases, on widely-known issues, like the introduction of the Ontarians With Disabilities Act, the parties often negotiate responsibility for new costs that may arise, but typically fail to negotiate the subject generally rather than to address one known issue, which leaves uncertainty when other issues arise.

Regulation 332/12, of the Ontario Building Code Act came into force on January 1, 2014. The provisions significantly expand the regulation of plumbing systems with the aim of preventing contamination of potable water supplies. Flooding increases the possibility of “backflow”, which is the reversal of the flow of potable water through a pipe, often taking contaminants or non-treated water with it. Backflow is far more likely where there are large amounts of standing surface water. The regulations aim to combat this problem by requiring the installation of backflow prevention devices in all buildings in Ontario that have been rated as being at “moderate” or “severe” risk of water contamination. Many municipalities have also enacted by-laws requiring buildings to be surveyed, permits to be obtained and plumbing systems to be inspected periodically, all with the aim of preventing contamination and requiring installation of backflow prevention devices where appropriate.

In many single tenant buildings, the tenant bears the responsibility for maintenance, repair and some or all replacements to the property. Rarely does a commercial lease allocate to a tenant the responsibility to perform any installations, changes or upgrades necessary as a result of any new or changing legislation, regulations or building codes. Leases often require the tenant to comply with all applicable laws, but the general clause is of course trumped by the specific requirements in a lease and maintenance, repair and replacement obligations will be more specific. So unless the tenant’s obligations are drafted to include the requirement to perform any installations, changes or upgrades required by law, regulation or code, (depending on the wording of the lease) a tenant may have no responsibility to do so.

In multi-tenant buildings where the landlord is performing the operating obligations or repairs, additional rent provisions in a net lease are usually drafted to allow a landlord to pass the costs of maintaining, repairing, and replacing parts of the building, building systems and commons areas on to the tenants. But it is questionable whether a new installation such as a backflow prevention device would be included in the list of items known as operating costs, which are recoverable from tenants. Some leases will include an operating costs definition broad enough to include “upgrades” to a building, or upgrades or installations required to keep the building up to the requirements of applicable laws. That is usually the exception as a tenant will traditionally negotiate to exclude the cost of any upgrades when the tenant has the bargaining power to do so.

Case law has made clear that labeling a lease “net” (or any derivation of that wording) is not necessarily sufficient on its own to require the tenant to pay for costs that are not specifically addressed in the lease. It is in the interests of both the landlord and the tenant to make the lease clear on what items can be recovered from the tenant as an operating cost. If the landlord expects to be able to recover the cost of items that are not traditionally seen as within the scope of maintenance, repair or replacement, then this should be expressly provided for in the lease.

In Riocan Holdings Inc. v. Metro Ontario Real Estate Ltd., the court considered whether resurfacing a parking lot was either a repair or a replacement and a capital item and the court concluded that “the dividing line between a capital expense/betterment and a repair/maintenance expense is not black and white. Indeed it is decidedly grey”. This just further shows the need to set out specifically in a commercial lease, the responsibilities of each party in order to avoid ambiguity or non-allocation.

The parties and their counsel should firstly seek agreement in principle on which party should be responsible for complying with new or changed governmental requirements regarding the property and secondly, reflect that understanding with clear and unambiguous language in the lease. Riocan and other cases have shown that reliance on general phrases such as “capital expenditure” to demarcate responsibility for costs between the landlord and tenant is inexact and can potentially lead to expensive litigation. Ideally, the lease should specify which classes of expenditure are to be recoverable from the tenant.

If the tenant is to be responsible for paying a portion of the cost of an item that would normally be considered a capital expense, a well advised tenant would ensure the landlord has the requirement to amortize such cost over the useful life of the item and charge through only the amortized portion each year of the lease term. This is best practice whether the capital expenditure relates to costs incurred in repair, maintenance or replacement, as well as installations and upgrades (whether the work is required by law or not).

While the new regulations regarding backflow prevention devices may not represent the biggest potential for unwanted costs for landlords and tenants, they do act as a reminder of the importance of clear drafting in order to manage future unforeseen expenditure.

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